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A New Era for Management Compensation in Change in Control Transactions
Reprinted from Deal Lawyers (January – February 2014)
10 Most Influential M&A Developments of this Millennium
Over the last several years we have witnessed a significant retrenchment with respect to change in control-related benefits for management in the context of both public company severance arrangements and private equity treatment of management teams post-transaction. We do not sense that the pressures on management compensation from shareholder advisory groups, compensation committees and private equity sponsors will relent in the near future.
In this environment, it is important for advisors to senior executives and management teams to try to advocate as best they can to protect their clients, even if at times it is only at the margins.
In the public company context, pressure from ISS and Glass Lewis, two prominent proxy advisory service firms, and other shareholder advisory groups, have resulted in material cutbacks to provisions which were prevalent in change in control arrangements beginning in the mid to late 1980’s and continuing up until the past two to three years.
Excise Tax Gross-ups. The contractual gross-up payment for the 20% excise tax imposed under Sections 280G and 4999 of the Internal Revenue Code on golden parachute payments with a value that exceeds 2.99 times an individual’s trailing five-year average W-2 compensation (a "280G Excise Tax Gross-Up") has become a rare provision to see in new change in control severance arrangements and has been eliminated by many companies from previously existing (and often longstanding) agreements (see Disney, among others).
Much more common now are provisions capping payments at the maximum level where golden parachute excise taxes would not apply (a "280G Cap") or providing for a so-called "valley" provision where the executive is either subject to a 280G cap or receives the full uncapped payments, if he or she is better off on an after-tax basis by receiving all payments and paying the excise tax. In some cases, the agreement will provide that the executive must net at least 10% more on an after-tax basis compared to the 280G Cap amount in order not to be subject to the 280G Cap. We are of the view, however, that, under certain specific circumstances, 280G excise tax gross-up payments may be warranted.
For example, we have advocated for certain new hires that a gross-up provision should apply for a limited period of time (a "wear away" gross up), particularly where a chief executive officer or other senior executive is hired by the company specifically to help prepare the company for possible sale. Such individuals are more likely to be disproportionately impacted by a 280G Cap or valley provision in the event of a change in control transaction occurring soon after they commence employment.
One provision which has had increased scrutiny in this era of 280G Caps is the post-employment restrictive covenant applicable to executives who are terminated following a change in control. While we have often advocated against non-competition clauses following a transaction because the executive's position may be eliminated in mid-career and job flexibility could be paramount, carefully constructed restricted covenants may, for golden parachute excise tax purposes, support the position that a portion of the severance payment be treated as reasonable compensation (i.e., for services performed by the executive). Under such circumstances, payments made in consideration for the covenant may be exempt from the excise tax calculation under Section 280G and thus shield some of the compensation from the mandatory reduction which may otherwise result from a 280G Cap. This position will be enhanced for federal tax reporting purposes if the value of the non-competition restriction is determined by a reputable independent valuation expert.
Single Trigger Severance. Much like the criticism directed at 280G Excise Tax Gross-Ups, the ability for executives to terminate employment and receive severance following a change in control without the necessity of demonstrating a "good reason"/constructive termination event (often called a “single trigger contract”) has come under heavy fire from shareholder advisory groups and, as a result, has become relatively rare, especially in new agreements.
While we believe such single trigger provisions may continue to have limited utility in keeping management together for a period following a merger or other change in control transaction, we believe it is incumbent for the practitioner to focus carefully upon the “good reason”/constructive termination definition when such single trigger provisions are not included in a change in control employment or severance agreement. Aside from the typical “good reason” triggering events relating to reductions in base salary or target bonus opportunity or a significant geographic relocation, careful attention should be paid to other good reason triggers for certain corporate level executives (e.g., the chief executive officer, chief financial officer, general counsel and corporate secretary).
In particular, there should be a focus on whether such executives should be deemed to have “good reason” without further demonstration if they are no longer truly serving in their pre-change in control roles (or no longer have the same level of authority, duties or responsibilities even if they are, technically, still serving in the same roles) because (x) they are now employed at a subsidiary of a public company post-acquisition or (y) their operations or budgets are significantly slashed though ostensibly their duties or responsibilities remain the same. Most acquirers will not challenge such an executive’s right to terminate for “good reason” when his or her position at their public company employer has been adversely affected as a result of the public company’s acquisition resulting in a downshift of duties or responsibilities.
Vesting of Equity. ISS has pushed for modifying single trigger vesting of equity upon a change in control to double trigger (i.e., change in control followed by a qualifying termination of employment) vesting and many companies have been compelled to follow the ISS recommendations and eliminate their single trigger vesting arrangements.
While we can appreciate the appeal of limiting the acceleration of vesting merely upon the occurrence of a change in control, we remain of the view that, in many circumstances, vesting of equity upon closing of the transaction is wholly appropriate. In particular, we think cash-based transactions may warrant such treatment for executives, as do transactions which are true acquisitions (as opposed to mergers of equals or near equals) following which the performance of the management team of the acquired entity will have little impact upon the overall performance of the buyer.
Finally, we often see insufficient focus in plan documents on the treatment of unvested outstanding equity awards when a subsidiary or division is sold and employees in the spun-out business (who are often deemed terminated because they have ceased to be employed by the plan sponsor or any subsidiary thereof as a result of the sale of their employing entity) have no contractual entitlement to having their outstanding equity awards rolled into the acquirer’s equity plan (if any such plan exists). Many plans do not either automatically accelerate vesting upon such deemed employment terminations or specifically authorize the administrator of such plan to so accelerate if it deems appropriate. We believe that more careful consideration should be placed upon treatment of executives who are impacted by such a disaffiliation.
Private Equity Issues. Private equity acquisitions may present a different set of issues for a management team post-change in control. In such transactions, the private equity sponsor will typically present the management team with new employment agreements, rollover equity (usually on an after-tax basis) and new equity grants. We have found with increased frequency that private equity buyers are making it more difficult for management to achieve liquidity with respect to their equity or even vest upon good leaver departures.
While put rights for executives which would enable them to withdraw their equity upon an involuntary termination without “cause” or a termination for “good reason” are now generally not “market” in private equity transactions, we continue to believe this right is an important ask, particularly for rolled over equity amounts. Perhaps more importantly, the ability to vest in equity grants upon terminations without “cause” or for “good reason” is a key provision enabling executives to protect, in part, the value of equity granted to them pursuant to compensation packages which are typically heavily weighted these days towards equity grants.
While most sponsors will not vest performance-based equity in the absence of hurdles being met, there is a case to be made that time-based equity should have an accelerated vesting component. Although private equity buyers are very reluctant to provide full vesting of time-based equity to severed executives, we have pushed for pro rata vesting or acceleration of the next vesting tranche (e.g., a deemed additional year of service towards vesting), and at times have been able to obtain full vesting. Care must be taken in analyzing the entire proposed package to make sure management is not placed in the position where they have rolled over significant amounts of equity (or the value thereof) from their acquired employer and could be terminated from employment in year 1 for any reason whatsoever with no vesting of grants and no immediate liquidity on the vested rolled over amounts.
Our view of trends occurring over the past five or so years is that the market has significantly shifted to make it more difficult for management to immediately reap the aforementioned benefits upon a change in control, a practice had been widely criticized in past years. In gazing into our crystal ball, we do not see these restraints loosening in the near future. In our view, there is room for a balanced treatment in such transactions, where the interests of shareholder advisory groups, public company acquirers and private equity sponsors are mollified, while management is offered adequate protections for the value that they have created over time.
|Michael S. Katzke|
|Henry I. Morgenbesser|